Central Banks and the Illusion of Stability

In the 17th century, Sir William Mallery was a well-master who lived on the outskirts of Rutland, England. In the English Civil War of 1648, the town had lost many of its fighting-age men in battle. Legend has it that in the Battle of Worcester, Sir William fled the battlefield while a dozen of Rutland's men perished. Consequently, he was labeled a coward. According to Sir William, he chased the enemy on foot and reports of his departure were just plain wrong. But nobody believed him. So, the coward moniker stuck with him, and he bristled at his ill-found reputation. He had always felt that his destiny was to be somebody important, but after his disgrace in battle, the townspeople ignored him. Consequently, he longed for recognition and respect. So, in 1655, he hatched a plan to have the town magistrate's wife, Lady Fielding, kidnapped so that he could publicly orchestrate a daring rescue. He conspired with a friend from a neighboring town, who dressed as the "black knight." Sir William would be the rescuer, or "white knight," and they would split the spoils.

The plan was for the black knight to kidnap Lady Fielding and keep her in one of Sir William's wells on the outskirts of town. The kidnapping itself went off without a hitch. The black knight rode into the town square on his horse and swooped up Lady Fielding in front of dozens of townspeople, including her husband, the town magistrate. Naturally, the townspeople were worried about Lady Fielding. As was customary at that time, they collected 1,000 shillings as a reward for anyone who rescued Lady Fielding. But without any fighting-age men in good standing, they quickly grew desperate. However, when Sir William told the townspeople a story about the deadly history of this mysterious black knight, they grew scared and offered the money in advance to entice somebody to find the "damsel in distress" and return her to safety. In front of all the townspeople, Sir William loudly proclaimed that he would not return without her, collected the money, and rode off on his horse.

But there was a problem. The black knight decided he wanted 80% of the rescue fund for putting himself at risk in the kidnapping, and Sir William decided that he also wanted 80% for himself in case the plot were ever discovered because he would face the penalty and his friend would live anonymously in another town. The black knight insisted that if he didn't get his share, he would take Lady Fielding with him and make her his slave. Sir William, realizing his plan was failing and not wanting any harm to befall Lady Fielding, fought the black knight. After a grueling exchange of blows, Sir William won. He threw 200 shillings at the black knight and kept 800 for himself.

Unbeknownst to Sir William, the exchange was witnessed by some children who were out hunting pigs and farrow. They discovered the ruse and went back to town to let the townspeople know. Sir William returned with Lady Fielding and shared a tale of his valiant efforts to rescue her and "possibly" mortally wound the black knight before he got away. While he was sharing this tale of gallantry and bravery, the boys from the hunt called him out. They revealed that Sir William wasn't a hero at all but, rather, the creator of an elaborate ruse to fool the townspeople for pride and money. Even though he did rescue a damsel in distress, she was in danger primarily because of him.

How is the tale of Sir William of Rutland any different from the Fed (and the US Treasury) rescuing the economy from the financial crisis of 2008? If the Rutland Ruse had happened today, the locus of discussion might be on the heroic rescue of Lady Fielding rather than her tragic kidnapping. Likewise, the locus of discussion regarding the financial crisis of 2008 is about the Fed's rescue and bailout of the banking system, not about the various policies that led to crisis. Of course, the Fed is not solely responsible for the crisis. To suggest otherwise is foolish. However, if we are to move forward, we must talk objectively about all the sources of the crisis and remove people and institutions that led us astray.

The story of Sir William of Rutland is a parable, but the glorifying of the Fed and bailouts is all too real. Recently, Timothy Geithner wrote a book called Stress Test, in which he laid out his justification for the bailouts, painting a picture of himself and Ben Bernanke as the saviors of the markets. Don't buy it. Over the past several years, we have also heard such justifications from Hank Paulson, Alan Greenspan, and Ben Bernanke. The combination of below-market rates, major trade imbalances, loose lending, fiat money, and perverse incentives helped the crisis spread all over the world. Below-market interest rates pushed the entire marketplace to borrow more than it otherwise would. Major trade imbalances enabled foreign central banks to purchase US Treasuries, which pushed rates down all along the yield curve, again affecting markets worldwide. Today's persistent trade imbalances are possible only because fiat currency is not backed by gold or specie of any sort, affecting whole countries and markets. Lack of coordination between the Fed, the Office of the Comptroller of the Currency, the Office of Thrift Supervision, and the Federal Deposit Insurance Corporation created large gaps in the regulatory framework, allowing non-bank lenders to lend to anyone and letting banks sell their entire exposure to originated loans to anyone, again affecting whole markets. Lastly, banks not only securitized loans, but they also sold and securitized their underlying interest in the first losses of the loan pools — which created the perverse incentive for lenders to originate without regard to the credit quality of the underlying borrower. Through securitization, bad loans were then sold in the form of mortgage-backed securities, collateralized loan obligations, and so on to investors all over the world. Just as treating Sir William as a hero would only encourage him to create more deceit, treating central banks as saviors only encourages more of the same.

Just as human beings like Sir William should be measured by the entirety of their actions, monetary policy should likewise be judged by the entirety of its effects. In other words, the financial crisis of 2008 did not just happen one day out of the clear blue sky. Bad choices were made by many players, including the Fed. Today, we stand at the 100-year anniversary of the Federal Reserve. Before it was formed, there was a different system in place. What system? What did it look like? How can a country operate without a central bank?

Before the Fed, the US government made rules and regulations for banks that affected lending and credit, so we must not assume that there was a complete void. And for much of this period, banks issued their own currencies. That’s right: Each bank had its own money stock and its own gold reserves or other form of specie. Each bank effectively operated as its own central bank, issuing currency that was backed by the trust of the public based on how well the bank was managed and how much gold (or specie) backed the money. When there were surges in demand for bank notes — and there were — banks issued more bank notes subject to the constraint of public trust (largely determined by the adequacy of specie to back the notes). The weakness of this system was that trust was localized. Bank notes were very valuable in close geographic proximity to the bank where they could be redeemed. The farther a bank note was from its primary issuer, the greater the discount required for another bank to redeem the note. For instance, if I had a $100 bill issued by my bank in Washington, DC, that same bill might be worth only $99 in Baltimore, and $96 in Chicago, and $90 in Los Angeles. However, this lack of trust was due to information asymmetry and a high cost of discovery. Today, because of the internet, the cost of discovery is virtually nil. And a competitive currency framework would encourage the transparency that people need to prudently manage their finances.

During the financial crisis of 2008, correlations between asset classes went to 1.0, meaning that virtually all asset classes fell in tandem. Why? What caused the crisis to be so uniform? Central banks. Some may counter that central banks rescued the financial system from imminent collapse. Although this is true, central banks were major contributors to the credit bubble, whose popping caused so much damage. The public seems to view central banks as the white knight who rode in to rescue the damsel locked in the tallest tower. How would you feel about that white knight if you learned that he was the one who locked her up?

Warren Buffett once famously said that he looks to invest in companies that could be run by a monkey because sooner or later, they will be. Of course, central banks are far more enduring and powerful than individual companies. Even if you agree with a particular approach or philosophy of a particular central banker, sooner or later, you won't. Why give that power to anyone? It's hard to imagine life without central banks. We've had them in the United States for 100 years. Yet the United States operated for nearly 83 years without one (1831–1913). Putting such vast power over other people's lives is dangerous. The Fed's contributions to creating the crisis are far from trivial. Praising their rescue efforts in 2008 is not only misguided; it is downright dangerous because central banks push millions, if not billions, of people to do things that they would not do on their own — be it consumers taking on larger mortgages, businesses buying back stock rather than investing in capital expenditures, or investors shifting their allocations toward riskier assets in search of greater yield. It's high time for a complete discussion about the role of central banks in our economy.

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